Old-Age Income Support in the 21st Century: The World Bank s Perspective on Pension Systems and Reform

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1 Old-Age Income Support in the 21st Century: The World Bank s Perspective on Pension Systems and Reform Michal Rutkowski, Director, Human Development, World Bank Paris, May 29, 2006

2 Focus of Presentation Motivations for Continued Emphasis on Pension Reform Foundations and Evolution of World Bank Perspective on Pension Systems and Reforms Reforms: State of Play Key Implementation Issues

3 Why Pensions Are Now More Important Than Ever Traditional Forms of Old Age Security Erode with Urbanization and Modernization Life Expectancies Are Increasing Longer Periods of Economic Inactivity/Dependence Old Age Burden Can Make Other Social Objectives Unaffordable Economic Development Makes Poverty Alleviation Among Elderly Possible Pension Systems can Impede or Stimulate Broader Economic Development

4 What Is Wrong With Existing Pension Systems Current pension systems do not deliver the expected coverage and benefit levels Uneven and unfair distribution of costs and benefits Unsustainable pension systems lead to the crowdingout of other social expenditures Unsustainable pension systems lead to macroeconomic instability (e.g. Brazil 1998) Most pension systems exhibit major labor market distortions Public management of assets has poor track record

5 Relationship Between Percentage of the Population over 60 Years Old and Public Pension Spending Pension spending as percentage of GDP Poland Luxembourg France Austria Italy Greece Sweden 8 Uruguay U.K. 4 0 Panama U.S. Costa Rica Japan Israel Australia China Jamaica Percentage of population over 60 years old

6 Ireland Implicit pension debt Implicit pension debt Sweden Germany Spain France Belgium Japan Austria Portugal Denmark Netherlands Canada United States United Kingdom Italy Public pension debt % of GDP

7 Difference between real annual compounded returns for publicly-managed pension funds and real income per capita growth in selected countries (1980s-1990s) 1990s) Average Peru Uganda Zambia Venezuela Egypt Tanzania Ecuador Costa Rica Guatemala Kenya Singapore Sri Lanka Jam aica Kore a Japan India Canada Malays ia Sweden US Morocco Philippine s -50% -40% -30% -20% -10% 0% 10% gross returns minus income per capita

8 Development of World Bank Position and Policies Publication of Averting the Old Age Crisis in 1994 Active participation in pension reforms of many types throughout the world Coordinated research and evaluation effort Assessment of experience and evolution of policies and priorities

9 Evolution of Perspectives on Reform Experience with realities of the Political Economy of reform Increased understanding of challenges to reach the lifetime poor Recognition of importance of initial conditions and cultural context of reform Appreciation of inter-actions with capital market development and administrative costs Inclusion of non-financial aspects of old age security

10 Current Perspectives on Pension Reform Reforms should be evaluated primarily in terms of the ability to achieve objectives and fulfill criteria rather than structure of new system Initial conditions and path of reform are as important as the ultimate form of the system Flexibility and diversification of risks through multiple pillars more important than the number of pension elements Need for non-contributory zero pillar in nearly all circumstances Funding remains important benchmark

11 Goals of a Pension System Primary goals: To provide adequate, affordable, sustainable and robust old-age income Adequate refers to both the absolute and relative level (i.e. poverty alleviation and income replacement) Affordable refers to the financing capacity of individuals and the society Sustainable refers to the financial soundness of the scheme, now and in the future Robust refers to the capacity to withstand major shocks, including those coming from economic, demographic and political risks Secondary goals: To create developmental effects by minimizing negative impacts (e.g. labor market) leveraging on positive impacts (e.g. financial market development)

12 Criteria for Evaluation of Reform Proposal Four primary content criteria Does the reform make sufficient progress toward the goals of a pension system, and meet distributive concerns? Is the macro and fiscal framework capable of supporting the reform? Can the administrative structure operate the new (multi-pillar) pension system? Have steps been prepared to establish to regulatory and supervisory arrangements and institutions to operate a funded pillar? Three primary process criteria Is there a credible commitment by government Is there local buy-in and leadership Does it include sufficient capacity building for implementation

13 Two Types of Reform Can Meet These Standards Parametric Change terms of existing system Paradigmatic (i.e. One pillar into multipillar or PAYGO Defined Benefit to Notional Defined Contribution)

14 Status of pension reform: an example of Europe Parametric Reform Attempt to rationalize pension system by seeking more revenues and reducing expenditures while expanding voluntary private pension provision. Austria, Czech Republic, France, Germany, Greece, and Slovenia Paradigmatic Reform Fundamental change in pension provision typically through introduction of mandatory funded pensions, drastic reform of PAYG pillar and expanded voluntary retirement saving. Bulgaria, Croatia, Denmark, Hungary, Italy, Latvia, Poland, Slovakia, Sweden,and UK.

15 Direction of Paradigmatic Changes Worldwide Actuarial systems Funding Defined Contribution principle Individual choice

16 Notional Defined Contribution Scheme DC systems, but remains unfunded Individual accounts, with contributions and notional interests credited Pension is calculated by dividing accumulated amount by life expectancy G-value Main issues: Choice of notional interest rate Choice of G-value Reserve funds against demographic and economic shocks

17 NDC Advantages Breaking reform deadlock in countries Harmonizing schemes between professions in countries Could be a common denominator in a group of countries (such as EU) Labor mobility between member countries Easy integration with funded schemes

18 Multi Pillar Pension Framework Zero Pillar- Non Contributory Social Assistance for Lifelong Poor 1 st Pillar - Publicly financed and managed PAYGO system to provide basic income protection 2 nd Pillar - Mandatory funded individual account system creating direct linkage between contributions and benefits 3 rd Pillar - Voluntary pension savings, individual or occupational 4 th Pillar Family and Inter-generational Support for Elderly

19 A Flexible Model Appropriate Combination of Pillars Depends on Conditions and History Successful system with only Zero and 3rd Pillar or Mainly 1st and 2 nd Success Depends on Ability to Align Characteristics of Elements With Needs and Objectives Strength of Multi-Pillar Approach is in Diversification of Risks and Ability to Align Elements with Specific Policy Objectives

20 Some Key Principles Each country should have a zero or basic pillar to address poverty among the elderly issue of who is most vulnerable, fiscal capacity, eligibility criteria and delivery mechanism If conditions are right, some pre-funding makes sense for economic and political reasons and can happen in any pillar issue of balancing benefits and costs, best organization and management A mandated and fully funded pillar provides a useful benchmark but not blueprint against which the proposed design of a reform should be evaluated

21 Why Funding Remains Important Makes Pension Debt Explicit - Diminishes Potential for Default Political Economy of Reform Strengthen the Sustainability of A Reform Portfolio Diversification by Individuals Wage vs Capital Market Returns Potential Behavioral and Savings Effects Developmental Effects

22 Market Capitalization and Contractual Savings 1996 (% GDP) MC/GDP 2 ZAF SGP 1.5 GBR CHE AUS USA 1 SWE CHL NLD CAN.5 NZL THA ESP BEL NOR DEU KOR ITA GRC PRT HUN AUT FRA JPN FIN DNK ISL CS/GDP

23 Capital Market Trade and Contractual Saving 1996 (% GDP) VT/GDP 1.5 CHE 1 USA NLD.5 0 ESP KOR DEU THA NOR FRA NZL ITA GRC AUTBEL PRT HUN SWE JPN AUS FINDNK CHL CAN ISL CS/GDP SGP ZAF GBR

24 WB Financial Support for Reforms : Bank has made 134 loans involving 58 countries with some type of pension component These loans total 20% of Bank lending Most of the World Bank s pension related lending goes toward funding multi-pillar projects Major share of World Bank loans to multi-pillar schemes were post-reform implementation loans World Bank lending to reforms with dominant second pillar is a small share of the total pension related lending (20 percent)

25 able 4. Most of the World Bank s pension related lending goes toward funding multiillar projects. Type of pension project Number of countries Total bank lending with pension component (US $m) Pension component (US $m) percent Pension component Number of loans Share of World Bank's pension related lending ( percent) on multi-pillar oans irst pillar econd pillar ulti-pillar loans irst and second irst and third ll otal

26 Graph 1. Major share of World Bank loans to multi-pillar schemes were post-reform implementation loans 7 6 number of loans Pre-reform loans Implementation loans

27 Some Key Design and Implementation Issues Taxation of pension schemes Costs and fees of funded and privately managed pillar Regulation and supervision of private pillars Retirement Products: Can the private sector deliver? How best to reform the unfunded pillar the Bank s love affair with NDCs How to improve the performance of centralized pension funds guidelines for governance How to assess poverty among the elderly and introduce social pensions

28 How to tax Pension Schemes Pensions should not be tax free (as is now the case in many Bank client countries) A back-loaded approach (EET) is favored over a front-loader approach (TEE) Voluntary and supplementary schemes may be tax favored, but within limits

29 Costs and fees: How to contain? Comparison of fee levels requires a life-cycle type approach in which all types of fees are considered Savings on administrative expenses through use of central clearing house (such as in Sweden) Limiting of marketing costs through blind accounts or switching constraints Limiting of asset management fees by restrictions on individual choice and, passively managed accounts, employers choice in provider, or competitive bidding of restricted number of asset managers

30 How to regulate and supervise private and funded pillars? Basic and largely uncontested regulation to be applied from the beginning, such as Appropriate licensing and capital requirements Full segregation of pensions assets from other activities Use of external custodian and transparent asset valuation rules More controversial rules include Market structure and portfolio choice Minimum funding standards for DBs Minimum rate of return guarantees

31 Regulation and supervision - II Non-controversial rules of supervision, e.g. Need of independent, proactive, well-financed and professional staff in supervisory body Vetting of application for licensing More controversial rules and questions, e.g. Single purpose (pioneered in Chile) or integrated supervisory agency Decision about range of institutions permitted to offer retirement products

32 How to provide retirement products? Focus so far on accumulation phase gives way to investigating the capacity of private sector to deliver appropriate retirement products (phased withdrawal, annuities,?) Joint work program of Financial Sector and Social Protection to review conceptual issues and experience Is there a demand-side problem to explain annuity puzzle such as Underestimating (remaining) life expectancy Strong bequest motive Incomplete insurance markets for other risks increase the marginal value of traditional (non-insurance) assets

33 Retirement Products - II Is there a supply side problem due to investment or longevity risk as appropriate assets to hedge these risks do not exist? Can private sector fully insure investment and longevity risks at reasonable/competitive prices? Is there a need to share the risk between individual and provider? Does the government need to assume both main risks and be the final provider of annuities? What type of providers should be allowed to offer annuities? What kind of products should be allowed? When must the private annuity market be ready? Should there be price indexation of annuities?

34 Summing-up Pension reform issues are now a fully multi-sector issue at the Bank - from safety-net type via social insurance to financial sector provisions Major progress and adjustments in the Bank s understanding in pension issues. Result of constant reevaluation, re-thinking and internal discussions Many conceptual and operational challenges are remaining, such as provision of social pension (zero pillar) and providing private sector annuities